Econ 311 Financial System

scope of financial system

- in developing countries the financial sector is a smaller part of the economy than in high income economies -it mainly consists of central banks -in developing countries many people and small firms do not have access to the formal financial system -micro-credit institutions serve people and that don't have access to the banking system -an informal, unregulated, financial sector also exists and plays a role in developing countries

Exchange Rate Policy and Monetary Policy

-a country's currency exchange rate can be fixed or floating -a floating exchange rate is determined by supply and demand forces -exchange rate regimes that are in-between fixed and floating also exist -we'll consider two types of fixed exchange rate: pegged exchange rate and currency board

Inflation

-a sustained increase in the general price level - is a monetary phenomenon: arises when growth in the money supply exceeds growth in money demand -in some cases it is made worse by civil war which causes a collapse in government revenue and increase in spending - mild inflation is annoying -moderate inflation does harm but is not catastrophic -hyperinflation is catastrophic -chronic inflation: double digit rate over a period of several years -acute inflation: 50-200% over 3 or more consecutive years. Affects income distribution, may or may not have negative affect on economic growth

Structure of financial system

-central bank: controls moneys supply, bank supervision -commercial banks: take deposits and make loans -investment banks: long term credit -other financial institutions: saving banks, insurance companies, pension funds, stock exchange, hedge funds. -regulatory agencies: aim to have financial institutions manage assets without excessive risk -the continued existence financial institutions depends on trust that may take a long time to build

High inflation

-has considerable real resource costs. Real resource costs are the resources used up as people try to avoid the effects of inflation -ex: Bolivia 1985- money changers, Brazil before 1994- shifting money between bank accounts, Zimbabwe until 2009- long lines before atms

As an economy grows:

-less liquid assets (stocks, bonds) become relatively more prominent -financial intermediation function of the financial system grows in importance

Inflation rates around world

lower since the mid 1990s, however, Argentina 25%, Egypt 26%, Venezuela 720%

Floating exchange rate

market determined but may fluctuate over time, no need to tie up large amounts of money as reserves, poses risk to investors

inflation alters the distribution of income:

the relatively well-off find it easier to avoid the effects of inflation compared to the poor

Other policies against inflation are ineffective because:

they are not credible, for them to be credible people must believe they will be carried out

high inflation has often resulted in abrupt economic policy change

under these circumstances making long term forecasts is very difficult so investment in long term projects is discouraged

Pegged exchange rate

- the central bank keeps foreign currency reserves and promises to intervene in foreign exchange markets to keep the exchange rate foxed. An independent monetary policy is possible. The central bank can act as lender of last resort to commercial banks. If foreign exchange reserves runs out, devaluation is necessary -Ex: bad weather causes drop in agricultural exports and the drop of exports results in a drop in the supply of foreign currency earned. Central bank sells reserves and maintains the exchange rate fixed. -ex: a false rumor spreads that a commercial bank may fail and customers run to withdraw their deposits. The bank has sufficient long term assets but not sufficient cash on hand to satisfy demands for withdrawals. The central bank lends to the commercial bank and the commercial bank does not fail. • Pegged Exchange rates: Several countries (Mexico 1994/5, Thailand/Indonesia/S. Korea/Malaysia 1997, Brazil 1999, Ecuador 1999) ran out of reserves and had to devalue. While the exchange rate was pegged, commercial banks and industrial or commercial firms found it cheaper to borrow in foreign currency. After devaluation, paying off these foreign currency debts became difficult. Depletion of reserves came about because of underlying policy weakness. • Example from Mexico (1994): higher domestic than trading partners' inflation. The true state of the economy and future economic policy was not fully revealed to investors. Once they found out something adverse about the economy, they feared that worse was to come and they pulled their investments out of the country bringing about depletion of reserves, devaluation and crisis.

Broad money supply (M2)

= currency+demand deposits+time deposits. M2 rises with GDP, 36% LI, 54% LMI, 79% UMI, 113% HI

Financial Development

Financial deepening: growth of financial assets that is faster than rate of economic growth. E.g. growth of liquid financial assets to GDP. An indication of the ability of financial system to finance investment. • Shallow and Deep finance: ratio of liquid assets to GDP. Characteristics of Shallow finance: high reserve requirements, interest rate regulation (also, commonly, negative real interest rates), non-price credit allocation. Deep finance does not have these characteristics. • A shallow financial policy limits intermediation (savers save less or ship their savings abroad) therefore the financial system has less money to lend to investors in the domestic economy. • Negative real interest rate: nominal interest rate minus inflation rate is negative. In some cases entry restrictions in the banking industry would result in high nominal interest rates. This is offset by interest rate ceilings. If inflation is sufficiently high, the interest rates become negative and this can be harmful: less financing available for investment, also those who do get a loan do not have a strong incentive to use the funds prudently. In addition non-price allocation of credit may not result in the most efficient use of resources. • Negative real interest rates make investment in capital goods relatively attractive therefore development generates relatively little employment in that case. • In general, deep finance is associated with higher economic growth rates.

Informal Credit markets

Informal creditors, e.g. moneylenders, family members, some traders, serve those who do not have access to the formal credit system. • Familiarity with their borrowers makes repayment more likely. • Borrowers know that future credit depends on old loans being repaid. • Typically high interest rates but convenient service.

Microfinance

Institutions that make making credit available to those who have no collateral. • Typically charge lower interest rates than moneylenders. • Started in the 1970s, now microfinance provides credit to billions of poor people in the developing world. • Rely on social pressure to enforce repayment. Each person in a borrowers' group gets a small loan, the group attends a weekly meeting where each member makes a repayment; failure to make a repayment has adverse consequences for all group members. Group members have an incentive to pressure others to make repayments. • Microfinance loans typically have very high repayment rates (e.g. Grameen Bank, BRI Bank 97% repayment rates). • Microfinance institutions are in principle self-supporting but how to finance their expansion. Non-profit and commercial micro credit institutions. There is a role for both types (the former serve the poorest).

Monetary Policy and Price Stability

Open market operations: the central bank buys bonds to increase the money supply, sells bonds to decrease it. • Reserve requirements: tie up part of commercial bank deposits as reserves that can't be lent. • Credit ceilings: limit overall commercial bank lending. Ineffective under fixed exchange rates when there is a large inflow of foreign capital. • Interest rate regulation: interest rate ceilings have been used to limit inflation in Latin America (but decrease the amount of funds lent and discourage saving); increases in deposit and loan rate in S. Korea and Taiwan (1960s) were important in helping start rapid growth (more saving, more lending, more careful use of loans).

Controlling and avoiding inflation requires:

balancing the government budget

Use of financial policy to stabilize economy:

control inflation, avoid financial panics, avoid recession.

Financial policy

control money supply, regulation to control risk

Important functions of the financial system

create money, financial intermediation, management of risk, stabilization

Argentina's experience on currency boards:

currency board 1991-2001, reduction in inflation after introduction of currency board, 1994/5 crisis in Mexico resulted in capital outflow from Argentina. Reduction in Argentina's money supply and sharp increase in unemployment. Several commercial banks failed and the currency board could not bail them out. Return of foreign capital when no devaluation took place. In 1998/9 neighboring Brazil suffered a financial crisis and devalued its currency. Argentina lost export markets after Brazil's devaluation. Argentina had government budget deficits since the early 1990s that were financed by foreign and domestic borrowing. By 2001 it became a parent that the public debt might not repaid in full. Default on domestic and foreign public debt in late 2001. Argentina abandoned the currency board in late 2001 in the face of a deep recession and political crisis. Devaluation of the peso (late 2001) and floating of the peso (2002). Firms that borrowed in dollars had difficulty paying their debts. Conversion of dollar bank deposits into pesos. Deep recession followed by recovery, renegotiation of public debt. • Currency boards also in: Hong Kong, Bulgaria, Bosnia and Herzegovina, Djubuti.

Fixed exchange rate

less risk to investors, serves as nominal anchor (signals that macroeconomic policy is credible)

Policies to combat recessions:

• Conventional monetary policy (e.g. open market operations) not very effective when interest rates become very low or when borrowers are not very sensitive to interest rate decreases (inelastic loan demand). • Stimulus spending (e.g. to construct infrastructure projects) may be more helpful.

Adopting another country's currency

• Ecuador (2000) abandoned its currency and adopted the U.S. dollar as its currency, giving up the ability to conduct independent monetary policy ("dollarization"). • Dollars come from exports, foreign investment, remittances, aid. • Sharp reduction of inflation rate in Ecuador. • Panama has used the US dollar as its currency since the 1950s and has had low inflation rates. El Salvador also adopted the U.S. dollar as its currency as of 2001 in order to be able to borrow at lower interest rates than previously. Zimbabwe adopted the South African Rand and U.S. dollar as its currencies in order to end hyperinflation in early 2009. Montenegro and Kosovo adopted the Euro as their currency in 1999. • During a recession or other economic crisis, a country that does not have a separate national currency (or has a currency board) is unable to devalue and this brings about sharper increases in unemployment than if there were floating exchange rates. • Ending a currency board may be less costly than returning to a separate national currency after abandoning it [issue new currency].

Does microcredit reduce poverty?

• If those who received microcredit experience a reduction in poverty is it because of the micro credit of for an unobserved reason that happens to be correlated with receipt of micro credit? • Randomized Controlled Study (India): exposure to micro credit increases new business formation and expansion, no significant effect on poverty. • Time to observe results, increasing time between repayment meetings.

Policy issues on pegged exchange rates

• Several of the countries that used to have pegged exchange rates (Mexico, Brazil, S. Korea, Thailand, Indonesia) now have floating exchange rates. • Some countries try to manage their exchange rates (e.g. in response to large capital inflows or commodity price changes). • Maintaining an exchange rate that does not clear the market (e.g. to keep imports cheaper) invites speculative attacks, may require restrictions on foreign exchange purchases or on imports and can be very costly.

Capital inflows and exchange rate management policies:

• Some countries accumulate reserves in order to keep their currency's value, relative to foreign currency, lower than it otherwise be. • Their aim is to avoid making their exports more costly to foreign buyers. • These policies keep imports into these countries more costly than they would otherwise be. • A number of countries in East Asia have accumulated significant reserves.

Currency board

• The board issues domestic currency fully backed by foreign currency reserves. It promises to exchange domestic currency for foreign currency at a fixed exchange rate. • Under a currency board the board can only issue, for example, 1 peso if it has on reserve one dollar (assuming a 1 to 1 exchange rate). Similarly if a citizen turns in one peso to the board, the board will exchange it for one dollar, and reduce the supply of pesos by one peso. The currency board cannot pursue independent monetary policy. The currency board promises to adjust the rest of the economy to maintain the exchange rate fixed. If it is willing to do that, there is no question that the exchange rate will remain fixed. A currency board is effective in reducing inflation. It also reassures foreign investors that they don't need to be concerned about possible loss of value of their investments from a currency devaluation. Automatic and credible policy mechanism